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CIMA - F3 > 12. Advanced Currency Risk Management > Flashcards

12. Advanced Currency Risk Management Flashcards

1
Q

Wha is money market hedging?

A

Taking the exchange rate NOW even though the payment is in the future by borrowing and lending on money markets and using the spot FX rate

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2
Q

What are the 5 steps in order to hedge future payments in $?

A
  1. Borrow in £ now
  2. Convert to $ at spot
  3. Deposit $ in a US bank, earning interest
  4. Settle payment out of $ deposit account
  5. Pay back £ loan and interest
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3
Q

What are the 5 steps in order to hedge future receipts in $?

A
  1. Borrow in $ now
  2. Convert to £ at spot
  3. Deposit £ in UK bank, earning interest
  4. Use receipt to pay back $ loan
  5. Withdraw £ deposit
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4
Q

What are the 4 steps to calculating the effective forward rate of a money market hedge used to pay in foreign currency?

A
  1. Calculate the amount needed to be saved in $ now by discounting the payment amount (X) to today using the US deposit rate
  2. Translate to £ at the spot rate
  3. Calculate what our £ loan will grow to at the payment date by using the UK borrowing rate (Y)
  4. Divide the future payment X by future loan value Y
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5
Q

What are the 4 steps to calculating the effective forward rate of a money market hedge used to receipt in foreign currency?

A
  1. Calculate the amount needed to borrow in $ now that will be paid of by receipt amount X, by discounting the receipt amount (X) to today using the US borrowing rate
  2. Translate to £ at the spot rate
  3. Calculate what the £ deposit will have grown to at the payment date by using the UK deposit rate (Y)
  4. Divide the future receipt X by future deposit value Y
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6
Q

What are FX futures?

A

Standardised traded contracts to buy or sell a set amount of currency at a set rate, at a standard date in the future

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7
Q

What do FX futures result in?

A

No currency exchange, only a net gain or loss in the currency in which the price is quoted

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8
Q

What are the 3 steps to set up a hedge using FX futures for an expected $ receipt?

A
  1. Buy £ futures (as you will want to SELL $ and BUY £)
  2. Choose the first available futures date after settlement
  3. Calculate the no. of contracts as $ receipt / contract value x futures price
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9
Q

What are the 3 steps to close out a hedge of using FX futures for an expected $ receipt?

A
  1. Close out by selling the same number of contracts
  2. Receive the net gain/loss: (Sell price - buy price) x no. contracts x contract value
  3. Convert the $ gain/loss to £ at the spot rate
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10
Q

What are the 3 steps to set up a hedge using FX futures for an expected $ payment?

A
  1. Sell £ futures (as you will want to BUY $ and SELL £)
  2. Choose the first available futures date after settlement
  3. Calculate the no. of contracts as $ payment / contract value x futures price
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11
Q

What are the 3 steps to close out a hedge of using FX futures for an expected $ payment?

A
  1. Close out by buying the same number of contracts
  2. Receive the net gain/loss: (Buy price - sell price) x no. contracts x contract value
  3. Convert the $ gain/loss to £ at the spot rate
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12
Q

What are the 2 pros of FX futures?

A
  1. Hedge downside risk
  2. Can close out a futures position at any time (more flexible than forwards)
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13
Q

What are the 4 cons of FX futures?

A
  1. Lose upside potential
  2. Standardised so may over/under hedge
  3. Basis risk if maturity does not equal transaction date
  4. You must post margin to the exchange
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14
Q

What is a currency option?

A

An agreement involving a right, but not an obligation, to buy or sell a certain amount of currency at a stated rate of exchange (exercise price) at some time in the future

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15
Q

What is the main pro of options?

A

They protect against adverse movements AND allow investors to take upside

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16
Q

What is the main con of options?

A

You must pay a premium

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17
Q

Based on the underlying currency, $, what is a call option?

A

The option to buy $ at a set price

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18
Q

Based on the underlying currency, $, what is a put option?

A

The option to sell $ at a set price

19
Q

What is the strike price?

A

The price you end up paying for the currency

20
Q

What are OTC currency options?

A

Paying a premium to buy a tailored option, that will result in exchange of currency if exercised, paying a premium in £

21
Q

What are the 3 steps to set up a hedge using FX OTC option in $ for an expected $ receipt?

A
  1. Buy a put option on $, as we will want to sell $ at the receipt date
  2. Choose a strike price
  3. Pay the premium in £
22
Q

What is the outcome of a $ OTC option hedge set up for a $ receipt, if the $ weakens?

A

We have bought an option to sell $, so as the $ is now weaker we convert at the STRIKE price as we get more money from our option

23
Q

What is the outcome of a $ OTC option hedge set up for a $ receipt, if the $ strengthens?

A

We have bought an option to sell $, so as the $ is now stronger we convert at the SPOT rate as we get more from the current rate than we would at our option strike price

24
Q

What are the 3 steps to set up a hedge using FX OTC option in $ for an expected $ payment?

A
  1. Buy a call option on $, as we want to buy $ at the receipt date
  2. Choose a strike price
  3. Pay the premium now in £
25
Q

What is the outcome of a $ OTC option hedge set up for a $ payment, if the $ weakens?

A

We have bought an option to buy $, so as the $ is now weaker we convert at the SPOT rate as it is cheaper at the current rate than at our option strike price

26
Q

What is the outcome of a $ OTC option hedge set up for a $ payment, if the $ strengthens?

A

We have bought an option to buy $, so as the $ is now stronger we convert at the STRIKE price as as it is cheaper

27
Q

What is a traded currency option?

A

Paying a premium to buy a standardised option, that will result in only gain or loss being exchanged in foreign $ if exercised, paying a premium in $

28
Q

What are the 4 steps to set up a hedge using FX traded option in £ for an expected $ receipt?

A
  1. Buy a call option, as we will want to sell $ and buy £
  2. Calculate the number of contracts by $ receipt / strike price x £ contract value
  3. Pay the premium in $, using todays spot rate
29
Q

What is the outcome of a £ traded option hedge set up for a $ receipt, if the $ weakens?

A

We gain on the option, as we can sell at the higher strike price:
(Spot - strike) x no. contracts x £ value

30
Q

What is the outcome of a £ traded option hedge set up for a $ receipt, if the $ strengthens?

A

We let the option lapse, as we get more £ for our $ by selling at spot rate

31
Q

What are the 4 steps to set up a hedge using FX traded option in £ for an expected $ payment?

A
  1. Buy a put option, as we want to buy $ and sell £
  2. Calculate the number of contracts by $ payment / strike price x £ contract value
  3. Pay the premium in $, using todays spot rate
32
Q

What is the outcome of a £ traded option hedge set up for a $ payment, if the $ weakens?

A

We let the option lapse, as we can buy $ cheaper at the spot rate

33
Q

What is the outcome of a £ traded option hedge set up for a $ payment, if the $ strengthens?

A

We gain on the option, as we can buy at the lower strike price:
(Strike - spot) x no. contracts x £ value

34
Q

What are the 2 main elements to setting a fair premium on an option?

A

The intrinsic value of the option (valuing of exercising today) and the time premium

35
Q

What are the 3 drivers of the time premium of an option?

A
  1. The standard deviation of the daily value
  2. The time to expiry
  3. The risk free interest rate

All higher = more valuable option

36
Q

What is the equation for the intrinsic value of an option?

A

Spot price - strike price

37
Q

What is the equation for the time premium value of an option?

A

Option premium - intrinsic premium

38
Q

What are arbitrage opportunities?

A

The simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the asset’s listed price

39
Q

What is the law of supply and demand in relation to arbitrage?

A

Undervalued item’s price will rise and overvalued item’s will fall as traders take advantage of the arbitrage, until equilibrium is regained

40
Q

What is the value at risk?

A

The maximum loss on given investments over a period time assuming normal market movements and a given confidence level.

41
Q

What is the equation for the value at risk for one period?

A

Z score based on confidence level x standard deviation

42
Q

What is the equation for the value at risk for n periods??

A

single period VaR x sqrt of n

43
Q

When calculating value at risk, what Z score would you use for an X% confidence level?

A

X% - 0.5

44
Q

When calculating the range of expected values, what Z score would you use for an X% confidence level?

A

X%/2

CIMA - F3 (13 decks)

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